Has Traditional Indexing Become an Outdated Relic?

ETFguide

Do the indexes behind your ETFs make a difference? Although many investors and traders don't think about it, the subtle differences between indexes can make a big difference.

Indexing History 101

The idea of market indexes dates back to the late 1800s when Charles Dow introduced the Dow Jones Transportation Average (NYSEArca: IYT - News). Dow calculated the indicator's value by adding up the closing price of the 11 leading transportation stocks. He used this same calculation method for other barometers, like the Dow Jones Industrial Average (NYSEArca: DIA - News), which is a collection of 30 blue chip stocks.

Dow's method is still used today for calculating the DJTA and DJIA and reflects the price of stocks rather than the value of the companies. For instance, a company with a tiny market value could have a $90 stock price while a larger company within the same barometer could have a $9 stock price - yet the smaller company would count 10 times more in the DJTA or DJIA versus the larger company.

Can an Index Beat the Market?While the original thought of benchmark indexes was to provide a way to measure the market's performance, indexes with alternative weighting schemes were introduced in the late twentieth century.

In the late 1990s, the idea of 'fundamentally weighted' indexes was born. Instead of weighting stocks by their market size or their price, companies were weighted by key financial metrics like book value, dividends, sales, and profitability. Instead of serving as mere yardsticks of the market, the chief aim of this new generation of indexes was launch investment products like ETFs, in order to give investors building blocks for their portfolios.

The Indexing Merry-Go-RoundIn October, State Street Global Advisors swapped the underlying indexes for five of its financial ETFs from Keefe, Bruyette, and Woods to Standard & Poor's. Meanwhile, the KBW financial indexes dropped by State Street were adopted by Invesco PowerShares for four ETFs. Those ETFs are the Bank ETF (NYSEArca: KBWB - News), regional bank ETF (NYSEArca: KBWR - News), capital markets ETF (NYSEArca: KBWC - News), and the insurance ETF (NYSEArca: KBWI - News).

The difference between the strategies behind the new financial SPDR ETFs linked to S&P indexes versus the old ones linked to KBW benchmarks is bigger than it appears. The S&P financial indexes equally weight financial stocks whereas the indexes managed by KBW use a market cap weighting method. This changed forced the SPDR S&P Bank ETF to immediately cut its exposure to large bank stocks like Bank of America and Wells Fargo. Also, large bank stocks have been performance laggards this year, and if that continues, the market cap weighted ETFs will likely underperform compared to the equal weighted strategies.

Unfortunately, changes to index providers and indexing strategies are occurring with more frequency. Over the past two years alone, almost 80 ETFs have changed their indexes.

Conclusion 

Traditional market cap weighted indexes like the S&P 500 (NYSEArca: SPY - News) have been outperformed by alternative weighted indexes over the past several years. Nevertheless, market weighted ETFs have the bulk of assets and they aren't attempting to beat the market.   

Although the actual performance history for fundamentally weighted ETFs is promising, it's premature to crown them as definifitive winners in every scenario. Yes recent history has certainly been a great testing ground of market extremes, but it's hardly a map of how the future will turn out fundamentally weighted ETFs. 

A core portfolio around market weighted ETFs still makes sense. And if you want to add satellite positions with extra money in fundamental weighted ETFs for good measure, try it. Maybe a little of both worlds can make a bottom line difference.   

 Figure 1: Fundamentally vs. Market Cap Weighted ETFs

Fund Name

Ticker

Expense Ratio

3 Yr. Annualized*

5 Yr. Annualized*

PowerShares FTSE RAFI US 1000

PRF

0.39%

+17.18%

-0.05%

iShares Russel1 1000 Index

IWB

0.15%

+13.21%

-0.69%

PowerShares FTSE RAFI 1500 Small-Mid

PRFZ

0.39%

+23.40%

+2.14%

iShares Russell 2000 Index

IWM

0.26%

+15.54%

-0.69%

PowerShares FTSE RAFI Emerging Markets

PXH

0.85%

+18.89%

-

Vanguard MSCI Emerging Markets

VWO

0.22%

+22.00%

+3.25%

PowerShares FTSE RAFI Dev Mkts ex-US

PXF

0.75%

+9.00%

-

iShares MSCI EAFE

EFA

0.35%

+8.29%

-4.54%

PowerShares FTSE RAFI Dev Mrkts ex-US S/M

PDN

0.75%

+18.75%

-

SPDR S&P International Small Cap

GWX

0.59%

+16.08%

-

PowerShares FTSE RAFI Asia Pacific ex-Jp

PAF

0.80%

+24.97%

-

iShares MSCI Pacific ex-Jp

EPP

0.50%

+21.41%

+3.41%

Data through November 28, 2011

Ron DeLegge is the Editor of ETFguide.com and Author of 'Gents with No Cents: A Closer Look at Wall Street, its Customers, Financial Regulators, and the Media' (Half Full Publishing, 2011). The book is due out on December 12.

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